Zero-Coupon Securities

Zero coupon securities - What are they and how do they work? If you are interested in finding out, please read the following post. However, keep in mind that this information is being provided for educational purposes only and is not designed to be complete in all material respects. Thus, it should not be relied upon as providing legal or investment advice. If you have any questions relative to the information provided herein, you should contact a qualified professional.

Zero coupon securities don't pay out their fixed rate of interest like other debt securities; they are issued at deep discounts and accumulate and compound the interest, then pay the fill face value at maturity. The primary attractions for the investor are mainly twofold: (1) they can be bought at very low prices because of the deep discount and (2) their yield to maturity is locked in, which takes the guesswork out of interest reinvestment.

The mathematical effects of a zero coupon security can seem astonishing, unless one is used to thinking in terms of compound interest over long periods of time. However, with every type of investment there are a number of disadvantages. For example, unless they are tax exempt, income taxes are payable as interest accrues and is payable out of money raised from another source; they are highly volatile; and their value at maturity can erode with inflation. Credit risk, especially with corporate zeros, can be greater than with a regular bond; if the issuer defaults after a certain amount of time has passed, the investor has more to lose, since nothing has been received along the way.

The following are principal types of zeros:

Corporate zero coupon securities: These are not usually recommended for individual investors because of credit risk and because the yield tends not to be competitive in relation to the risk.

Strips and STRIPS: Strips are U.S. Treasury or municipal securities that brokerage firms have separated into principal and interest which, represented by certificates (the actual securities are held in escrow), are marketed as zero coupon securities under proprietary acronyms. Although the obligor is actually the broker, the escrow arrangement assures a high degree of security. Free of risk altogether are STRIPS, Separate Trading of Registered Interest and Principal of Securities, the Treasury's acronym for its own zero coupon securities. STRIPS are Treasury bonds issued in the traditional way but separated into interest and principal components at the discretion of bondholders using book entry accounts at Federal Reserve Banks.

Strips of mortgage backed securities placed privately or by government agencies are also available. To enter the Federal Reserve's book entry system, however, federal agency strips must satisfy a technicality requiring a minimum of 1% of the principal of the underlying loans; in other words, they can't be 100% interest.

Municipal zero coupon securities: These securities are issued by sate and local governments and are usually exempt from federal taxes and from state taxes in the state of issue. They provide a convenient way of providing for future goals of high bracket investors who get an after tax benefit from their lower interest rates. One caveat, however: some are issued with call features, which can defeat the purpose of a zero from the investor's standpoint, so avoid those.

Zero coupon convertibles: Introduced in the mid-1980's, these convertibles come in two varieties: one, issued with a put option, coverts into common stock, thus providing growth potential; the other, usually a municipal bond, converts into an interest paying bond, thus enabling the investor to lock in a rate, then, 15 years later, to begin collection the interest.

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